Musings on World events from the perspective of a Social and an Economic Liberal.

Tuesday, January 19, 2010

The Rollercoaster Ride of the Pound

I must admit I am feeling a bit smug: I anticipated that the UK inflation numbers would be worse than expected and as a result delayed transferring my cash off shore. The numbers are so bad though, that my long position in Sterling may be only needed for a few months.

Some may ask themselves why such bad news would cause the Pound to go up. The answer is all about interest rates. The market is increasingly anticipating that the Bank of England will have to raise interest rates substantially in order to deal with an inflation rate that is already headed to the top of its supposed permissible range. Is this good news? Very obviously not: the costs of borrowing for British companies and households is going to rise substantially, and probably very rapidly. On the other hand if the Bank fails to act quickly enough, then inflation could really take a hold: with equally dire consequences for the UK cost of living. Yet the UK economy remains in a highly fragile state, large rises in interest rates could kill off the tentative recovery before it even starts. The Bank of England is damned if it acts too rapidly, but equally damned if it acts too slowly.

Goldman Sachs put out a very optimistic report on the UK economy only this morning, saying that the 25% fall in Sterling over the past 18 months would boost the economy dramatically. The problem is that the UK economy is now largely public sector services- precisely the area where there is the least currency effect. Manufacturing output is only 9% of GDP: it is too small to have a real impact on the growth of the economy. In fact the fall in the currency is highly inflationary given the massive trade gap between the giant import and puny export numbers- and invisible earnings have been badly hurt by the disproportionate British investment in the USA whose currency has also depreciated versus the Eurozone where it has appreciated.

Goldman Sachs of course will be seeking to place a record amount of Gilts onto the market later in the year, though naturally it would be cynical to suggest that their consistently bullish view of the UK is linked to the huge fees that they gain from doing business with its government and monetary authorities.

For what its worth, my view of the British economy in 2010 is that this months inflation figures will be followed by even worse (indeed record monthly) figures next month. There may even need to be an emergency rate rise as early as March. That rise will need to be at least 100 basis points, possibly 150, and will be followed by several other rises in quick succession. This will be particularly true if the polls continue to point to a hung Parliament after the general election. Unemployment, meanwhile, will rise sharply too: the classic stagflation mixture. If demand for the big Gilt auctions later in the year is low and the cuts proposed by any new government are unconvincing then both the UK triple-A and Sterling will come under renewed pressure. Rates will have to rise substantially, particularly bearing in mind that the average base rate since the Bank of England was founded is 5%. Eventually the highly overvalued UK housing and corporate real estate markets will have to capitulate. This in turn may place renewed pressure on the banking system. I would not bet against rates above 6% before the year end.

As for Sterling: in a word: volatility. As the interest rate cycle tightens rapidly, I think it could peak at somewhere around €1.30. However the election, gilt auctions and need for recession inducing government cuts, not to mention looming pressure on the credit rating makes me think that it will test parity again before the year is out.

We will see if I am so smug in June, which is when I hope to have cut my long Sterling position to a short one.

Ahem you are not alone in foreseeing inflation and interest rate rises . Ultimately this is a result of creating a structural fiscal imbalance that the Liberal Party agitated for more of through out its foolish Genesis

I am not at all sure a dose of inflation is not the least worst course open to us though